5 Introduction Sources of differences across countries that lead to gains from trade: The Ricardian model (Chapter 3) examines differences in the productivity of labor between countries. Differences in Technology The Heckscher-Ohlin model (Chapter 4) examines differences in labor, labor skills, physical capital, land, or other factors of production between countries. Differences in Endowments

6 Comparative Advantage and Opportunity Cost The Ricardian model uses the concepts of opportunity cost and comparative advantage. The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used.

7 David Ricardo, Theory of Comparative Advantage Amassed a large fortune from financial market speculation Mostly, he made a ton speculating on the outcome of the Battle of Waterloo Friends included James Mill, Jeremy Bentham, Thomas Malthus

8 A One-Factor Ricardian Model 1. Labor is the only factor of production. 2. Labor productivity varies across countries due to differences in technology, but labor productivity in each country is constant. 3. The supply of labor in each country is constant.

9 A One-Factor Ricardian Model 4. Two goods: wine and cheese. 5. Competition allows workers to be paid a competitive wage equal to the value of what they produce, and allows them to work in the industry that pays the highest wage. 6. Two countries: home and foreign. 7. OK, we have the supply side, but what about demand? Later.

10 A One-Factor Ricardian Model A unit labor requirement indicates the constant number of hours of labor required to produce one unit of output. The production technology a LC is the unit labor requirement for cheese in the home country. For example, a LC = 1 means that 1 hour of labor produces one pound of cheese in the home country. a LW is the unit labor requirement for wine in the home country. For example, a LW = 2 means that 2 hours of labor produces one gallon of wine in the home country. A low unit labor requirement means high labor productivity!

11 A One-Factor Ricardian Model Labor supply L indicates the total number of hours worked in the home country (a constant number). Cheese production Q C indicates how many pounds of cheese are produced. Wine production Q W indicates how many gallons of wine are produced.

12 Production Possibilities The production possibility frontier (PPF) of an economy shows the maximum amount of a good that can be produced for a fixed amount of resources. The production possibility frontier of the home economy is: a LC Q C + a LW Q W L Total amount of labor resources Labor required for each pound of cheese produced Total pounds of cheese produced Labor required for each gallon of wine produced Total gallons of wine produced

13 Home s Production Possibility Frontier

14 Production Possibilities The opportunity cost of cheese is how many gallons of wine Home must stop producing in order to make one more pound of cheese. The opportunity cost of cheese appears as the absolute value of the slope of the PPF. Q W = L/a LW (a LC /a LW )Q C

15 Relative Prices, Wages, and Supply So, what will be produced, and where? Let P C be the price of cheese and P W be the price of wine. Due to competition, hourly wages of cheese makers equal the value of the cheese produced in an hour: P C /a LC hourly wages of wine makers equal the value of the wine produced in an hour: P W /a LW Because workers like high wages, they will work in the industry that pays the higher wage.

16 Trade in the Ricardian Model Now let s introduce trade Suppose the home country is more efficient in wine and cheese production. It has an absolute advantage in all production: its unit labor requirements for wine and cheese production are lower than those in the foreign country: a LC < a * LC and a LW < a * LW where * notates foreign country variables

17 Trade in the Ricardian Model Even if a country is the most (or least) efficient producer of all goods, it still can benefit from trade.

18 Trade in the Ricardian Model Suppose that the home country has a comparative advantage in cheese production: its opportunity cost of producing cheese is lower than in the foreign country. a LC /a LW < a * LC /a * LW When the home country increases cheese production, it reduces wine production less than the foreign country would.

19 Trade in the Ricardian Model Since the slope of the PPF indicates the opportunity cost of cheese in terms of wine, Foreign s PPF is steeper than Home s.

20 Foreign s Production Possibility Frontier

21 Home s Production Possibility Frontier

22 Trade in the Ricardian Model Before any trade occurs, the relative price of cheese to wine reflects the opportunity cost of cheese in terms of wine in each country. For example, at Home: P LC /P LW = a LC /a LW This is because workers will only work in the industry with the highest wage! Wages must be equal for both goods to be produced.

23 Trade in the Ricardian Model In the absence of any trade, the relative price of cheese to wine will be higher in Foreign than in Home It will be profitable to ship cheese from Home to Foreign (and wine from Foreign to Home) This alters the relative price of cheese and wine Where does the relative price of cheese to wine settle?

24 Trade in the Ricardian Model To see how all countries can benefit from trade, need to find relative prices when trade exists. So, we need to consider both supply and demand (as usual) First calculate the world relative supply of cheese: the quantity of cheese supplied by all countries relative to the quantity of wine supplied by all countries RS = (Q C + Q * C )/(Q W + Q * W)

25 Relative Supply and Relative Demand (cont.) Relative demand of cheese is the quantity of cheese demanded in all countries relative to the quantity of wine demanded in all countries

26 World Relative Supply and Demand

27 World Relative Supply and Demand Study that chart, and read the textbook carefully!

28 Gains From Trade Gains from trade come from specializing in the type of production which uses resources most efficiently, and using the income generated from that production to buy the goods and services that countries desire. where using resources most efficiently means producing a good in which a country has a comparative advantage.

29 Gains From Trade (cont.) Generally, opening up to trade leads to the price of a good falling in between its pre-trade levels in the two countries.

30 Trade Expands Consumption Possibilities

31 A Numerical Example Unit labor requirements for home and foreign countries Cheese Wine Home a LC = 1 hour/lb a LW = 2 hours/gallon Foreign a * LC = 6 hours/lb a * LW = 3 hours/gallon What is the home country s opportunity cost of producing cheese?

32 A Numerical Example (cont.) The home country is more efficient in both industries, but has a comparative advantage only in cheese production. 1/2 = a LC /a LW < a * LC /a * LW = 2 The foreign country is less efficient in both industries, but has a comparative advantage in wine production.

33 A Numerical Example (cont.) With trade, the equilibrium relative price of cheese to wine settles between the two opportunity costs of cheese. Suppose that the intersection of RS and RD occurs at P C /P W = 1 so one pound of cheese trades for one gallon of wine. Trade causes the relative price of cheese to rise in the home country and fall in foreign.

34 A Numerical Example (cont.) With trade, the foreign country can buy one pound of cheese for P C /P W = one gallon of wine, instead of stopping production of a * LC /a * LW = 2 gallons of wine to free up enough labor to produce one pound of cheese in the absence of trade.

35 A Numerical Example (cont.) With trade, the home country can buy one gallon of wine for P W /P C = one pound of cheese, instead of stopping production of a LW /a LC = two pounds of cheese to free up enough labor to produce one gallon of wine in the absence of trade.

36 Relative Wages Relative wages are the wages of the home country relative to the wages in the foreign country. Productivity (technological) differences determine relative wage differences across countries. Remember: these are reflected in the unit labor costs.

38 Relative Wages (cont.) In the home economy, producing one pound of cheese costs $12 (one worker paid $12/hr) but would have cost $24 (six paid $4/hr) in Foreign. In the foreign economy, producing one gallon of wine costs $12 (three workers paid $4/hr) but would have cost $24 (two paid $12/hr) in Home.

39 Relative Wages (cont.) Because foreign workers have a wage that is only 1/3 the wage of domestic workers, they are able to attain a cost advantage in wine production, despite low productivity. Because domestic workers have a productivity that is 6 times that of foreign workers in cheese production, they are able to attain a cost advantage in cheese production, despite high wages.

40 Do Wages Reflect Productivity? Do relative wages reflect relative productivities across countries? Evidence shows that low wages are associated with low productivity. Wage of most countries relative to the U.S. is similar to their productivity relative to the U.S.

41 Productivity and Wages Source: International Monetary Fund, Bureau of Labor Statistics, and The Conference Board

42 Do Wages Reflect Productivity? (cont.) Other evidence shows that wages rise as productivity rises. As recently as 1975, wages in South Korea were only 5% of those of the United States. As South Korea s labor productivity rose (to about half of the U.S. level by 2007), so did its wages (which were more than half of U.S. levels by 2007).

43 Misconceptions About Comparative Advantage 1. Free trade is beneficial only if a country is more productive than foreign countries. But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. High costs derive from inefficient use of resources. The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently.

44 Misconceptions About Comparative Advantage (cont.) 2. Free trade with countries that pay low wages hurts high wage countries. While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. Consumers benefit because they can purchase goods more cheaply. Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages.

45 Misconceptions About Comparative Advantage (cont.) 3. Free trade exploits less productive countries. While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade. Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation may result without export production. Consumers benefit from free trade by having access to cheaply (efficiently) produced goods. Producers/workers benefit from having higher profits/wages higher compared to the alternative.

46 Transportation Costs and Nontraded Goods The Ricardian model predicts that countries completely specialize in production. But this rarely happens for three main reasons: 1. More than one factor of production reduces the tendency of specialization (Chapter 4). 2. Protectionism (Chapters 8 11). 3. Transportation costs reduce or prevent trade, which may cause each country to produce the same good or service.

47 Transportation Costs and Nontraded Goods (cont.) Nontraded goods and services (ex., haircuts and auto repairs) exist due to high transport costs. Countries tend to spend a large fraction of national income on nontraded goods and services. This fact has implications for the gravity model and for models that consider how income transfers across countries affect trade.

48 Empirical Evidence Do countries export those goods in which their productivity is relatively high? The ratio of U.S. to British exports in 1951 compared to the ratio of U.S. to British labor productivity in 26 manufacturing industries suggests yes. At this time the U.S. had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the U.S.

49 Fig. 3-6: Productivity and Exports

50 Empirical Evidence Compare Chinese output and productivity with that of Germany for various industries using 1995 data. Chinese productivity (output per worker) was only 5 percent of Germany s on average. In apparel, Chinese productivity was about 20 percent of Germany s, creating a strong comparative advantage in apparel for China.

51 Table 3-3: China versus Germany, 1995

52 Empirical Evidence The main implications of the Ricardian model are well supported by empirical evidence: productivity differences play an important role in international trade comparative advantage (not absolute advantage) matters for trade

53 Summary 1. Differences in the productivity of labor across countries generate comparative advantage. 1. A country has a comparative advantage in producing a good when its opportunity cost of producing that good is lower than in other countries.

54 Summary 3. Countries export goods in which they have a comparative advantage - high productivity or low wages give countries a cost advantage. 4. With trade, the relative price settles in between what the relative prices were in each country before trade.

55 Summary (cont.) 5. Trade benefits all countries due to the relative price of the exported good rising: income for workers who produce exports rises, and imported goods become less expensive. 6. Empirical evidence supports trade based on comparative advantage, although transportation costs and other factors prevent complete specialization in production.

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